CCH-JOURNAL, TAXES-The Tax Magazine, March 2005, Seeking Shelter —Should Corporate Tax
Directors Set a New Course?
Seeking Shelter —Should Corporate Tax Directors Set a New Course?
©2005 M.C. Ferguson, Jr.
By M. Carr Ferguson, Jr.*
M. Carr Ferguson, Jr. is Senior Counsel to Davis Polk & Wardwell’s Tax Department, involved in the Tax
Controversy Practice Group, in New York City. Mr. Ferguson is also on the faculties of New York
University and the University of San Diego law schools.
Introduction
Business and cultural trends, more than changes in the law, have refashioned the demography of the tax
department and its mission. A corporation’s tax department of 50 years ago might seem a bit dull to today’s
denizens. The tax director typically would have had an accounting background, and perhaps have been
recruited from one of the Big Eight firms. The staff, smaller than today’s, would have been trained for the
primary tasks of the office: translating the company’s financials to tax data, preparing tax returns and
defending them during audits. Their primary missions were timely tax liability measurement, prediction
and compliance. A premium was put upon mastery of financial and tax accounting, accuracy, reliability and
promptness. Reputations for these admirable traits were cultivated and prized as well by the auditing and
tax departments of the Big Eight firms in those distant days. A Big Eight firm’s identity as return preparer
bore some of the cachet of the firm’s financial certificate. Surprises were unwelcome. A no-change letter at
the end of an audit or an unremarkable agreed adjustment was a source of pride, rather than grounds for
suspicion that the tax department was not aggressive enough. Tax controversies tended to be rooted in
unavoidable ambiguities which could not be resolved in advance by planning or guidance from the IRS or
independent counsel.
Today, tax directors and their staff may have more background in tax law than accounting. They perceive
their department’s role not just as the staff functions mentioned, but also the line function of increasing
their company’s earnings by minimizing its effective tax rates. Some corporations have come to view their
tax departments as profit centers, to be managed and compensated accordingly. Companies have also
staffed up their accounting and legal departments, bringing professionals in house to shoulder other
functions tax departments must support. Outside legal, accounting and tax assistance is retained by such
companies only when they can add value beyond what a company’s own professional teams are expected to
provide. This change in expectations has not been lost on the companies’ outside accounting firms, which
now volunteer to perform, besides their auditing and reporting functions, the more lucrative role of tax
advisor. Indeed, the accounting firms have exceeded their corporate clients in building tax departments
with specialists trained in the tax law rather than auditing and reporting. The result has been that the old
traits of conservatism, predictability and reliability have been subordinated by many companies and
accounting firms to creative planning. Over the last several years, the surviving Big Four competed
aggressively in devising and selling to corporate clients schemes to reduce effective income tax rates. A
casualty of this trend has been the reputation of corporate tax directors and the major accounting firms as
the backbone of voluntary compliance with the corporate income tax.
As voluntary compliance has declined, so has the ability of the IRS to sustain corporate tax revenues. Paul
Braverman, writing recently in the AMERICAN LAWYER, described these trends in corporate tax
administration.1 From 1996 through 2001, business tax returns filed with the IRS increased by 17 percent,
while Congress cut the IRS staff by eight percent.2 During the prosperous years from 1999 to 2002,
corporate tax revenues collected by the IRS actually dropped by 34 percent. 3 Over the same period of time,
the IRS and the General Accounting Office (GAO) estimated revenue lost to abusive tax shelters at $85
billion. In recent years, the corporate income tax as a percentage of federal revenues has declined
irregularly but inexorably, while federal government reliance on revenues from payroll and individual
income taxes has increased. All this happened, of course, before the recent passage of the American Jobs
Creation Act of 2004 (“the Jobs Act”),4 which has been estimated to cut another $140 billion from
corporate income taxes over the next 10 years.5
Paradoxically, there is no reliable data that American businesses have correspondingly benefited. 6 Shortrun earnings boosts promised by sheltered taxes can come at a disproportionate long-term cost to
companies as well. Recent headlines illustrate that the costs of engaging in stealth reporting and aggressive
tax transactions can be high.7 Aside from negative front-page publicity to corporations and their
professional advisors, company time spent on managing tax disputes is a wasteful opportunity cost beyond
the direct costs in interest and penalties on the deferred taxes. The revised financial statements that the
United Parcel Service (UPS) issued, following its loss in the Tax Court and before its successful appeal in
the Eleventh Circuit, are an example of how these costs may escalate.8 UPS’s public filings for 1983
revealed that UPS had projected that it would benefit from $16 million in tax savings for 1984, which was
the first year of the reinsurance arrangement at issue in the case. After the Tax Court disallowed UPS’s
effort to move its shipping insurance premiums offshore, assessed interest and imposed penalties, the
projected tax savings turned into a cost in excess of $200 million. Worse yet, the Tax Court decision
involved only the 1984 tax year, whereas the reinsurance arrangement at issue apparently had continued
until 1999. After the Tax Court decision, UPS recorded a reserve in its financial statements for additional
tax assessments of almost $2 billion for all years. Although the validity of the reinsurance arrangement was
upheld on appeal, eliminating the reserve charges, the disproportion between UPS’s tax savings originally
estimated and the threatened deficiencies serves as a stark warning of the potentially unfavorable odds that
can be involved in disputes of this type.
The gaming of the corporate income tax raises not only fiscal and financial issues. It also raises issues
concerning the professional responsibilities of tax directors and outside advisors to their companies and the
public. Can auditors independently judge the adequacy of tax reserves for aggressive schemes colleagues in
their own firm have sold the company? Are lawyers employed by accounting firms (or the firms
themselves) practicing law when they sell opinions as to the tax consequences of so-called “tax products”?
If so, do they have further ethical questions of their own independence, duty of inquiry, client
confidentiality and fee sharing with lay partners? The Treasury’s new rules of good practice and portions of
the Sarbanes-Oxley legislation provide for less biased evaluations of the tax risks lurking in aggressive
underreporting practices, thereby addressing the concerns of corporations and their shareholders that such
evaluations are biased. As such, the new rules affect both a tax director’s own responsibilities to his
company and what may be expected from independent advisors.
This paper offers only one tax lawyer’s perspective on how these developments affect corporate tax
practice generally. Left to others is the task of dissecting the new law.
Historical Responses to Individual Tax Shelters
Published accounts of aggressive corporate tax and accounting practices may have stimulated steps to curb
aggressive corporate tax planning. It was the press, not regulators, that first told us of the scheme featured
in the Merrill Lynch special purpose partnerships to manufacture paper offshore capital gains and valuable
onshore capital losses to erase taxes on business-related capital gains.9 Enron’s baroque partnership
transactions that were used to improve reported financial statements likewise came to general notice
through press accounts of corporate financial revisions rather than through the SEC or IRS auditing
agents.10 Although the particulars of such artificial devices might be novel, Congress and the IRS have
seen a tax shelter epidemic before. The individual tax shelter wave of the 1960s and 1970s affords useful
lessons in the causes and likely cures of the recent assault on the corporate income tax. While there are
important differences in the two tax shelter waves, by recalling how individual tax shelters were eventually
brought under control, a perspective is provided on today’s anti-shelter campaign.
Then as now, the IRS was confronted with bizarre strategies to feed taxpayers’ desires to lower effective
tax rates, which were higher than today’s. There were time lags between the marketing of a particular
device and IRS awareness of the device. The IRS typically learned of the devices through published
accounts in the press or trade articles. The system of partnership taxation under subchapter K in the 1970s
and 1980s, which by today’s standards was comparatively rudimentary, played a role in spawning the tax
shelter wave of the period. At the time, subchapter K permitted individual tax shelters to make wide use of
limited partnership arrangements based on artificial allocations of income, loss and basis. 11 Passive losses
generated by nonrecourse loans were generally deductible, and limited partnership interests in the same
loss-generating partnerships could be sold to many different passive investors. Their multiplicity eventually
threatened to overwhelm the IRS. The Tax Court faced an onslaught of participants armed with favorable
opinions and determined to defend the validity of their arrangements through litigation.
The efforts of Congress, the IRS and the courts to contain individual tax shelters evoke a sense of déjà vu.
Procedural counterattacks were more hastily devised and came first. The IRS improved its strategies for
identifying and resolving shelter issues efficiently. Changes were made in the law to increase disclosure of
shelter transactions. Other changes addressed the responsibilities of taxpayers and their advisors for tax
positions claimed on returns. Civil penalties for taxpayers and promoters alike were dramatically
strengthened to take the profit out of the audit lottery. Rules governing the standards for furnishing
professional opinions became more stringent.
Promoters of shelters and the partnerships they sponsored became targets of the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA).12 Under the regime, promoters faced increased civil penalties and
criminal prosecutions. As part of TEFRA, Congress added Code Sec. 6700, which imposed penalties for
the promotion of abusive tax strategies and asset overvaluation. Congress also added Code Sec. 7408 to
grant the Treasury authority to institute actions to enjoin promoters of shelters. 13 In addition, TEFRA
consolidated partnership audits, so that the IRS no longer needed to audit each individual limited partner in
order to issue deficiency notices. Instead, Code Sec. 6231, also enacted as part of TEFRA, required the
designation of a tax matters partner for each partnership. This enabled the IRS to attack tax shelters in
limited partnership form efficiently without having to undertake audits of all the partners.
In 1984, in the Deficit Reduction Act,14 Congress added Code Sec. 6111, which required tax shelter
promoters (as defined in part by reference to a “tax shelter ratio”) to register their products with the IRS
before offering the products for sale. The IRS, the Treasury and, finally, Congress addressed the problem of
the inundated Tax Court docket in three ways. First, the IRS instituted its Designated Issue Program,
according to which particular issues were designated to be litigated, not settled. Mass settlements were also
part of the IRS’s strategy. A series of “formula settlements” was developed that usually allowed taxpayers a
deduction only for their actual costs incurred as part of the transactions. The Tax Court broke the logjam of
pending cases by working with counsel to try cases representative of many others. The resulting opinions
built a new body of decisional law grounded on the business purpose and economic effect doctrines, which
strengthened the IRS’s hand and discouraged many taxpayers from pressing on. 15
Procedural reforms and an increasingly skeptical Tax Court could not stem the tide alone. Ultimately,
substantive changes in the law had to be, and were, developed. Changes to subchapter K and its regulations
were made to conform more closely to the economic effect of partnership arrangements. The partnership
special allocation rules were also revised16 ; other statutory changes of this era included limitations on
investment interest17 and pre-paid interest,18 and the original issue discount rules.19 In 1986, individual
income tax rates were reduced20 and prospective amendments to the Code were designed to take the profit
out of the passive losses, which lay at the root of most individual tax shelters. 21 Section 469 of the Tax
Reform Act of 198622 limited passive activity losses and credits to income and taxes from similar
activities. These changes in the 1986 Act, more than any other, deflated the individual tax shelter
industry.23 After 1986, the tide of individual tax shelters ebbed.
Current Corporate Tax Shelters
This thumbnail history cannot begin to capture the years of debate, false starts and frustrations that
characterized the individual tax shelter wave. However, in turning to consider the present campaign against
corporate tax shelters, it reminds us that we may still be in a relatively early phase where procedural
responses are those most easily mounted. No substantive silver bullet has been found and the search for one
may be more difficult than last time, for corporate tax shelters are not cast in similar molds, nor do they
sound themes similar to most of the individual tax shelters, which dealt with nonrecourse debt, limited
partnerships and optimistic factual assumptions. Beyond the common characteristics of dubious business
purpose, economic substance and artificial readings of the law, they escape convenient classification.
A potentially disturbing difference between individual and corporate tax shelter litigation involves choice
of forum. Individual shelter cases tended to flow into the Tax Court for at least two reasons. The
prepayment of asserted deficiencies was a daunting expense for many individuals, and the interest rates
then prevailing, though higher than today, were lower than most individuals’ borrowing rates. Deferrals in
payment attributable to litigation delays were thus part of some taxpayers’ strategy. Consequently, the Tax
Court was able to play a major part in stemming shelter litigation in a series of decisions favorable to the
IRS and skeptical of taxpayer claims of business purpose, economic purpose or claimed after-tax values.
Corporations are better able to finance tax refund litigation than are individuals. For moot companies, the
difference between tax refund interest rates and their own internal hurdle rates is insignificant. Their choice
of forum is based on their sense of their chances of prevailing. Easier access to the federal district courts
and the Claims Court as courts of first instance in more cases may change the calculus of litigation risk. 24
Early procedural counterattacks, however, have been aimed at the pre-litigation stages of a corporate tax
dispute. Some have been in place long enough for interim evaluation. Code Sec. 6111(d) assumes that
corporate tax shelters may be identified by how they are marketed, even if they can not yet be defined.
While the absence of a working definition still confounds efforts to categorize them, anecdotal evidence to
date illustrates that corporate tax shelters have proliferated over the last several years, and by now may
have crested.25
Tax directors over the last few years have received so many unsolicited proposals for reducing corporate
taxable income that most have by now developed a healthy skepticism. A few years ago, so-called “tax
products” were sometimes offered with the furtiveness of a seller of naughty postcards, with warnings not
to disclose them to anyone, even outside counsel, and at contingent prices tied to tax savings rather than
service. While many of these proposals did not pass a first reading, plausible ones placed tax departments
in the dilemma of investing in a careful analysis or rejecting a possible opportunity to reduce their
company’s taxes. Outside counsel called in to review these schemes found that most frequently bore little
relationship to their clients’ business or to the law. More recently, tax directors have seen how unpleasant
the consequences can be of a “product” gone wrong and show a growing concern over civil and criminal
penalties26 and negative press. Sensitive to this new skepticism, the very accounting firms which marketed
these products, now acting as auditors, demand more support for aggressive tax positions taken by
companies —some requiring “should” opinions from a law firm before doing so. As a result, tax reserves
are subject to increasing scrutiny by accounting firms and the SEC alike.
In November 2003, the Permanent Subcommittee on Investigations to the Senate Committee on
Governmental Affairs published a report on its investigation of the development and marketing of four tax
products by one of the Big Four accounting firms. The subcommittee’s report concluded that “[t]he sale of
potentially abusive and illegal tax shelters has become a lucrative business in the United States” that
“continu[es] to wrongfully deny the U.S. Treasury billions of dollars in revenues.”27 Predictably, these
strategies are far more complex than the individual tax shelters of the 1970s and are packaged for review by
more technically sophisticated consumers. Still, the apparent departure from standards of objective due
diligence expected of auditing firms and the degree of optimism in legal conclusions is disturbing. The
legal analyses underlying these schemes provoked questions as to whether a truly independent, competent
professional would have concurred in them. The Permanent Subcommittee on Investigations found that
professionals within the firm selling these products harbored doubts about them that were not passed along
to their prospective customers. Quotations from internal memoranda reveal disagreements within the firm
as to the soundness of the positions taken and how they should be disclosed on returns.
As with the individual tax shelters, the IRS has taken steps to level the playing field. So far, governmental
reactions to the current tax shelter wave have followed the patterns of those to the individual tax shelters.
The early steps (1) require increased disclosure of such transactions; (2) impose heavier responsibilities on
corporate officers and their boards for positions taken on their companies’ tax returns; (3) improve
detection of shelter issues on audit and resolve them more quickly; (4) create new legislation which, while
shelving efforts to codify the business purpose doctrine, grants broad authority to the IRS to dictate
disclosure and increases civil penalties for noncompliance; and (5) propose new professional standards of
good practice for those who provide tax opinions. Eventually, if past is prologue, Congress may find
substantive rules and the courts doctrinal tests to chill the corporate tax shelter industry. This process,
however, could take years of debate and false starts. In the meantime, corporate tax directors and their
counsel need to assess the impact of the battery of new procedural rules on their responsibilities to their
companies and clients. These five groups of procedural initiatives warrant separate discussion.
1. Disclosure: Increased Obligations
Code Sec. 6111 dates back to the battle waged against the tax shelter industry in the 1980s. During the
second half of the 1990s, Congress and the Treasury saw the use of confidentiality agreements between
promoters and purchasers of tax shelter products —whether qualifying as tax shelters under Code Sec.
6111(c) or not —as a growing phenomenon.28 These agreements were troublesome for at least two reasons.
First, the agreements delayed discovery of the underlying product by the IRS. Second, they lent an aura of
proprietary value to schemes that otherwise might have been analyzed openly within the tax community
before they could be widely sold.
Congress attacked these attempts at stealth by enacting Code Sec. 6111(d) as part of the Taxpayer Relief
Act of 1997,29 which expanded the definition of tax shelter to include “any entity, plan, arrangement, or
transaction” that is, inter alia, offered “under conditions of confidentiality.” By defining confidential
arrangements as tax shelters under Code Sec. 6111, Congress required the promoters of confidential
arrangements to register the confidential products, or abandon the veil of confidentiality. Under Code Sec.
6111, substantial penalties are assessed against promoters who fail to register a confidential transaction.30
Ironically, in lieu of stipulations that proposals must be held in confidence, some shelters have been
presented to tax directors recently with a requirement that they permit disclosure of any aspect of the
transaction to any party without limitation.31
While Code Sec. 6111(d) has discouraged furtive marketing of questionable tax strategies, it has not
guaranteed affirmative disclosure. For that purpose, other approaches were necessary. In July 1999, the
Treasury issued a report advocating a more rigorous disclosure and list-maintenance regime in response to
new and aggressive tax shelter strategies, and to alleviate some of the burdens shouldered by an
understaffed IRS.32 Temporary regulations were issued several months later in February 2000. In February
2003, the Treasury promulgated final regulations implementing the new regime. 33 The centerpiece of the
new disclosure regime was Reg. §1.6011-4, which has propounded a general set of “reportable
transactions.” If a tax return is calculated on the basis of any such a transaction, the taxpayer must attach
Form 8886 to the return, describing the details of the transaction and listing all promoters and advisors
involved in the transaction. The regulation also required the taxpayer to retain all relevant documents
related to the transaction. Although the regime did not include statutory penalties of consequence, the
American Jobs Creation Act of 2004 did.34 Thus, tax directors must keep their knowledge current as to the
list of reportable transactions.
There are six categories of reportable transactions under the Code Sec. 6011 regulations. Most discussed
among them is the category of “listed transactions,” discussed below. The others, generally described, are:
 “confidential transactions,” which are defined similarly as in Code Sec. 6111(d);
 “transactions with contractual protection,” or those in which the promoter agrees to refund all or some
of the fees paid by the taxpayer if the purported tax benefits of the transaction are disallowed;
 “loss transactions,” which are transactions that generate a specified amount of loss —$10 million in any
single year or $20 million in any combination of years for corporations —under Code Sec. 165;
 “transactions with a significant book-tax difference,” or transactions in which the tax characterization of
a particular item differs from the book characterization of the item by more than $10 million, on a gross
basis; and
 “transactions involving a brief asset holding period,” namely, one in which the taxpayer holds an asset
45 days or less and claims a credit exceeding $250,000, such as the dividend stripping activity examined in
the Compaq Computer Corp. and IES Industries, Inc. cases. 35
The regulations offer few exceptions. The categories seem drafted to require only inflexible, objective
application. They are cumbersome for corporate tax departments and the IRS alike. Companies deciding
what transactions to report are likely to take the safer course, reporting many unobjectionable transactions
caught up in the sweeping regulatory definitions.36 If so, the IRS in turn will face the challenge of
reviewing a torrent of worthless disclosures.
“Listed transactions” comprise a special subset of reportable transactions. The other five categories of
reportable transactions are intended to compel disclosure to the IRS of transactions that contain hallmarks
of abuse, but that may nonetheless withstand IRS scrutiny. Listed transactions, and “substantially similar”
transactions, however, are those specifically identified by the IRS as tax avoidance measures to be
challenged on audit. The initial list of 10 such transactions was described in Notice 2000-15, released in
February 200037 together with the reportable transaction regime itself. By the time of this Conference,
there are 30 as a result of supplementary notices.38 Though prospective in terms of disclosure and
challenge, the notices can only follow those transactions that are used widely enough to be discovered and
analyzed. The notices chill their continued use,39 but their more important salutary effect may be their
warning by example that schemes currently in vogue can become the subject of a future notice before the
corporate return can be filed.40
Corporations engaging in a reportable transaction are not the only parties that must be concerned with
disclosure requirements under the new regime. Under Reg. §301.6112-1, organizers and sellers of
potentially abusive transactions and material advisors to any such transactions must maintain lists of any
and all parties to whom they provide a “tax statement” regarding the tax consequences of any aspect of the
transaction. The IRS may request these lists on 20 days’ notice 41 and need not rely on return selection or
audits to uncover an undisclosed reportable transaction. Indeed, the IRS may be alerted to its existence
through lists maintained by the advisors who assisted the taxpayer in implementing the transaction.
2. Corporate Responsibility for Return Positions: The Sarbanes-Oxley Act of 2002
In July 2002, in the wake of the Enron and other accounting scandals, Congress produced the SarbanesOxley Act (“Sarbanes-Oxley”).42 Sarbanes-Oxley addresses corporate governance of financial matters
broadly, but in the process affects the responsibilities of tax departments in those companies which have
issued publicly traded securities. Sarbanes-Oxley requires that such companies establish an audit
committee, consisting chiefly of independent board members. The audit committee is made responsible for
the appointment, compensation and oversight of the auditor employed by the company and is charged with
pre-approving not only the auditor’s performance of audit services, but also the auditor’s performance of
nonaudit services. Nonaudit services are restricted out of a concern that auditors remain objective regarding
nonaudit advice. Companies comprising the Standard and Poor’s 500 spent more than $3.7 billion for
nonaudit services in 2000 —an amount more than three times that spent on audit services in the same
period, and without separating the functions the danger of greater gain from the former affecting the latter
is obvious.43 In an attempt to eliminate perceived conflicts of interest, 44 Sarbanes-Oxley proscribes certain
nonaudit services the company auditor cannot provide to the company, even if approved by the audit
committee. Among these per se banned services are bookkeeping, valuation services, management
functions and legal and other expert services unrelated to the audit.
Notably omitted from the proscription list are nonaudit tax services. Necessarily, an audit includes some
tax-related activities, such as reviewing the provision of tax reserves and assessing the valuation allowance
for deferred tax assets. Therefore, the SEC has issued final rules indicating that all services performed in
order to comply with accounting standards, including tax services such as these, are part of “audit
services.”45 Thus, an audit committee’s pre-approval of an accounting firm to act as auditor for the
company allows the auditor to render these integral tax services. Yet “tax services” also can refer to tax
compliance, tax planning and tax advice, which are not integral to the audit. All three of these activities can
present difficult judgment calls regarding tax risks. Since they are not among the per se banned services,
the company auditor may continue to perform such nonaudit services, if the audit committee separately
grants pre-approval.46
The roles of first providing strategic tax planning, for example, and then weighing the financial adequacy
of reserves against potential additional taxes resulting from adoption of such advice are patently in conflict.
Criticism has been leveled against Congress’ failure to prohibit company auditors from performing
nonaudit tax services.47 Critics urge that the Big Four be barred from offering any tax advisory services,
even for nonaudit clients, since all four firms market such similar and competitive tax reduction strategies
that disinterested valuation of a tax product of another firm is compromised. The problem is real, and the
failure of Congress and professional standards boards to address it has created confusion. Professionals
have experienced an anomalous reversal of roles for accountants and lawyers. Outside tax counsel have
been accustomed to receiving waiver-of-privilege letters from public corporations, requesting them to
discuss tax positions with auditors reviewing the adequacy of tax accrual reserves. In recent years,
however, the process has been reversed. Outside counsel have received requests from corporate clients to
review tax positions being proposed by their “independent” accounting firms. Public accounting firms have
a duty to the public. Lawyers’ allegiance is to their clients. Investors and their corporations would be better
served if tax counsel alone provided external tax planning advice and auditors returned to their roles as
objective evaluators of the adequacy of reserves against tax positions taken by the company. 48 The SEC,
however, has only ventured so far as to caution audit committees to “scrutinize carefully the retention of an
accountant in a transaction initially recommended by the accountant, the sole business purpose of which
might be tax avoidance and the tax treatment of which might not be supported in the Code and related
regulations”49 and has mandated audit committee pre-approval specification of services authorized. As a
practical matter, this relegates to the audit committee the task of policing the auditor’s conflicts in giving
tax advice.
The SEC, so far, has provided only broad principles on how this is to be accomplished. Monetary limits or
approval of broad categories of services (e.g., “tax compliance”) is not sufficient, and audit committees
may not leave discretion with management to determine whether a particular service is permitted. 50 The
company must disclose in its public filings not only its approval of nonaudit services by the auditor and the
corresponding “Tax Fees” it pays for the services, but also the committee’s pre-approval policies and
procedures.51 These, however, are only cautionary rules. What explains the hesitance of Congress and the
SEC to step in directly when the AICPA has been unwilling to acknowledge the conflict? The question
recalls the defeat of Arthur Levitt’s proposal a few years ago to divorce audit and tax services by the
lobbying interests against such reform.52 Absent bolder action by the SEC, regulators, analysts and
investors will depend upon audit committees to create stricter policies regarding the provision of tax
advisory services separate from return preparation itself.
Two other provisions in Sarbanes-Oxley address abusive tax strategies and accounting manipulation. First
and foremost, companies must establish internal controls over financial reporting, the effectiveness of
which must be assessed and certified to by management in the company’s annual report. Tax directors will
be involved in drafting and implementing the controls regarding the reporting of tax items. These controls
include guidelines explicitly describing procedures to be followed when the company engages in listed or
other reportable transactions. Second, Sarbanes-Oxley contains the widely publicized provision that
mandates CEO and CFO certification as to the accuracy of annual and quarterly reports and accompanying
financial statements. This should prompt these officers to review with the tax director the tax positions the
company has taken before certifying the financial statements and perhaps, require similar certifications
from the tax director.53 The legislators’ hope seems to be that some top management which urged their tax
departments to lower effective tax rates every year, may gain a new appreciation of the balancing values of
compliance. Efforts in the last few years to require the CEO or CFO him- or herself to sign the company’s
tax return, however, have been unsuccessful.54
Tax lawyers who regularly counsel publicly held companies have sensed that the new legislation and
disclosure rules along with increased publicity have ended their clients’ appetite not only for listed tax
shelter products but, frequently, for any aggressive tax planning. It would be foolhardy, however, to declare
the problem over. Privately held corporations are less concerned with the “brand” or public image issues of
publicity, and even publicly held companies move with vogues of tax administration. Their withdrawal
from the game may be caused by the current calls for greater corporate accountability, but there are always
later innings.
3. Enforcement: Improved IRS Auditing and Resolution of Corporate Tax Shelter Issues
As it did during the 1970s and 1980s, the IRS has taken steps to alleviate its case burden and to make more
efficient use of its limited resources. Faced with the growing disparity between government and corporate
tax staffs, the IRS announced new initiatives at the end of 2003 that would expedite corporate audits in its
Large and Mid-Size Business (LMSB) Division.55 IRS Commissioner Mark Everson declared that
corporate audits, which now take an average of 38 months, should be completed in only 15 to 18 months.
The IRS also has announced that it and the Justice Department’s Tax Division will pursue civil, criminal
and Circular 230 violation investigations concurrently.56 There has been a 58-percent increase in the
investigation and prosecution of cases from 2001 to 2004.57 Increased audit and criminal coverage without
adequate staff runs the risk, of course, of slippage in spotting issues, but wider coverage and improved rules
for disclosing issues may more than offset missed adjustments.
Addressing this last point, in early 2004, the IRS introduced its new Schedule M-3, for corporate taxpayers
in the LMSB Division with assets totaling $10 million or more. 58 Schedule M-3, which taxpayers may use
in lieu of Schedule M-1, is designed to reconcile the income or loss a taxpayer reports for financial
accounting purposes with the income or loss reported on its tax return. The new form is premised on the
expectation that it will reveal with greater transparency book-tax disparities symptomatic of return
positions worth examining. The IRS may also refer to the new Schedule M-3 in selecting returns for audit.
Efficiency in spotting novel tax positions and speed in resolving them are twin goals of these procedures.
In complementary moves, the IRS has instituted a number of initiatives, such as the Fast Track programs
for mediation and settlement,59 limited issue focused examinations (LIFEs)60 and the pre-filing agreement
(PFA) program.61 These initiatives are in addition to the IRS goal of achieving faster, more focused audits.
There also has been a gradually increasing willingness by the IRS to refer unresolved disputes to
independent mediation and arbitration, offering the IRS and corporate taxpayers a favorable alternative to
long and costly litigation.
Accelerated resolution is also in the interest of corporate taxpayers. Deferral at today’s deficiency interest
rates and penalties is no longer a profitable strategy. Apple Computer’s Code Sec. 482 litigation in the Tax
Court of over a decade ago was a prototype of these methods of cutting litigation delays and costs. 62 The
parties in Apple Computer negotiated a Tax Court order under Rule 124 for a “baseball” arbitration of the
issue. Each party submitted its final proposed Code Sec. 482 adjustment to an independent arbitrator bound
to choose one. While the arbitrator ultimately chose the IRS’s proposed adjustment rather than Apple’s, the
company benefited as soon as the parties’ final positions were known. Apple’s tax reserves could be
reduced to the IRS’s final proposal, a figure significantly below the 90-Day Letter proposed adjustment,
with a corresponding release back to income of a portion of the excess. Both sides also benefited from the
savings in direct and indirect litigation costs.
Not all procedural initiatives of the IRS have been as welcomed as those just mentioned. In 2002, the IRS
announced a change in its general policy not to summon tax accrual work papers, stating that it would
henceforth compel their disclosure when a return claimed a benefit from an abusive transaction that the IRS
identified as such.63 Its original position —announced after the Supreme Court upheld the IRS’s authority
to summon tax accrual work papers64 under Code Sec. 7602 —had been that the IRS would only ask for
the papers in highly unusual circumstances.65 Some argue that the broadened authorization has not gone far
enough. Recently, former IRS Chief Counsel B. John Williams, Jr. argued that the IRS should make greater
use of its ability to request work papers, a conclusion he attributes to the IRS’s need to shorten audits —the
current audit time is being trimmed from an average of five years to an 18-month target time frame —
coupled with the need of revenue agents to find the right issues on examination while on the tighter
schedule.66
Such a policy shift would produce serious concerns among taxpayers. Tax accrual work papers might,
indeed, provide “roadmaps” for expedited audits by giving the IRS insights into the companies’ auditors’
evaluation of possible tax litigation risks, as well as companies’ likely willingness to settle. 67 However, the
risk of exposure of such sensitive information impairs the ability of the auditors to record nonadversarial
judgments about the company’s tax contingencies. Threatened exposure to the IRS may influence
companies to be less forthcoming about their tax contingencies with their auditors, endangering the quality
of financial statement reporting.68 Indeed, the very existence of the IRS’s power to summon work papers
rests, to some extent, on its reluctance to use it. In Arthur Young, the Supreme Court declined to expand the
list of common-law privileges to include tax accrual work papers, based in part on its conclusion that the
IRS’s demonstrated “administrative sensitivity to the concerns expressed by the accounting profession.
...”69
This debate complicates the issue between companies and their auditors regarding access to privileged
communications from outside counsel opining on tax contingencies. Waivers to enable auditors to evaluate
the adequacy of reserves typically call for unlimited access to such opinions. If, in turn, copies of the
opinion become routine targets of IRS audits (and government counsel, in the event of litigation,)
companies may seek to limit auditors’ access to the opinions and counsel may become more guarded in
expressing reasons for their assessment of litigation hazards. Neither would seem useful developments for
companies needing unqualified opinions or for the investing public.
In addition to the more tangible worries over accurate financial statements and auditing, the debate over tax
accrual work papers touches a broader concern about the nature of the relationship between the IRS and
taxpayers. Beyond a certain level, forced disclosure may change from an incentive to a deterrent for selfassessment. The issue is reminiscent of the controversy over the Eleven Questions in the 1970s, which also
involved the IRS summons power under Code Sec. 7602. In 1976, the IRS issued an Internal Revenue
Manual Supplement that required agents to ask, at a minimum, a set of 11 questions of corporate officials 70
who had to answer under penalty of perjury.71 The questions were not characteristic of those that elicit
specific information during an audit. Instead, they amounted to a broad inquisition of corporate actions,
designed to uncover schemes for generating and hiding cash that could be used to bribe foreign officials or
business persons.72 After extended and intense criticism from the corporate community and the tax bar, the
questions were reworded, and their use was made no longer mandatory in all circumstances. 73 An example
of the concerns expressed about the Eleven Questions is provided in the following passage from a letter to
the IRS Commissioner from the retiring chair of the ABA Section on Taxation:
[T]he self-assessment system can function only in a setting which engenders a considerable
degree of mutual respect and cooperation between taxpayers and the IRS. That setting is
destroyed if the starting premise is that all taxpayers of a certain group or size are sufficiently
suspect to warrant their treatment as potential tax evaders. The deficiencies of a relative few —
albeit disturbing to note their size and stature in the business community —do not warrant the
assumption that large numbers of additional taxpayers have been similarly careless or callous in
the discharge of their responsibilities under the Internal Revenue Code. 74
The same concern would reappear following an increase in requests for tax accrual work papers. Even Mr.
Williams has observed that the IRS should “focus on enforcement rather than compliance.” 75 He conceded
that the “overriding mission” of the IRS is to collect the revenue that is owed, rather than deterrence
through criminal prosecutions. 76 When the IRS substitutes enforcement as its primary function, observed
Mr. Williams, it undermines confidence in the IRS itself, and risks “a wholesale train wreck of revenue
collection” by failure to foster cooperation from the taxpaying community. 77 Balancing enforcement and
compliance requires that the IRS and corporate tax professionals re-establish the atmosphere of mutual
cooperation, which existed when corporate tax departments placed a premium on accuracy and reliability
rather than gaming the tax laws.
If the level of voluntary compliance by companies fails to rise, the IRS must demand more transparency on
corporate audits. In the current legislative environment, agents are as handicapped as companies’ tax
departments by the growing complexity of the law. Even with the Administration’s current budget proposal
that would allocate an additional 10 percent to enforcement resources, 78 the IRS head count has remained
relatively stable while corporate tax departments continue to grow. Large corporate audits, of course,
require a disproportionate allocation of skilled resources. Unresolved issues on audit only compound the
problem, as the growing recourse to alternative dispute resolution strategies attests. However salutary, there
is a stern limit on the IRS’s capacity to carry through to litigation cases like ACM.79
Obviously, the IRS needs more examiners with skill and training to ferret out abusive shelters and more
experienced tax lawyers to defend the resulting adjustments and prosecute criminal violations. Even with
existing resources, however, IRS corporate tax auditors possess a resource that they did not enjoy during
the campaign against individual shelters. Unlike individuals, publicly held corporate taxpayers must
disclose and file their financial statements. Sarbanes-Oxley, Schedule M-3 and other procedural steps
discussed above which strengthen financial reporting obligations also strengthen the hand of the tax
auditor. Just to take advantage of this additional data, however, requires the IRS to have the capacity to
review the disclosures and request the records upon which they are based.
In turn, rules requiring record retention are critical, and one provision of Sarbanes Oxley addresses this.
Sarbanes-Oxley adds new Section 1519 to Title 18, branding as a felon for obstruction of justice anyone
who “... knowingly alters, destroys, mutilates, conceals, covers up, falsifies or makes a false entry in any
record, document or tangible object with the intent to impede, obstruct or influence the investigation or
proper administration of any matter within the jurisdiction of any department or agency of the United States
... in relation to or contemplation of any such matter or case. ...”80 This anti-shredding provision came on
the heels of the difficult prosecutions of Arthur Andersen for shredding audit papers on the eve of the
Enron grand jury investigation81 and a Credit Suisse First Boston banker for e-mailing his staff a reminder
of the company’s document retention and destruction policies after learning of an SEC investigation of the
company.82 Those cases were brought under older obstruction of justice statutes, which required the
prosecutor to prove a specific intent to obstruct an identified official proceeding.83 These standards have
proven to be difficult to meet, discouraging prosecutions for shredding evidence. The new provision’s
expansion to document destruction “in relation to or contemplation of” an investigation or case may make
obstruction cases easier to prove.84 At a minimum, new Section 151985 should be taken as a warning to tax
directors regarding the establishment of clear document retention policies for unaudited return years.
This battery of new record keeping and disclosure provisions prompts the question of whether the IRS
should give them a chance to work before the IRS resorts to more frequent summonses for tax accrual work
papers. Sometimes a better use of such drastic power is simply to wield it, rather than to exercise it
indiscriminately and lose it.86
4. Legislative Responses: The Jobs Act and Sarbanes-Oxley
The President signed the Jobs Act into law on October 22, 2004. 87 The Jobs Act imposes a new penalty for
failure to disclose reportable transactions and listed transactions on the tax return. 88 It punishes
nondisclosure of a reportable transaction other than a listed transaction with a fine of $50,000 and
nondisclosure of a listed transaction with one of $200,000. 89 For individuals, the fines are lower.90 The
Jobs Act also created a new regime of disclosure requirements and penalties, which apply to material
advisors.91 Taxpayers with reporting obligations to the SEC must also disclose to the SEC any penalty that
is assessed against the taxpayer for failure to disclose a reportable transaction. 92 The Commissioner of
Internal Revenue can waive the penalty for nondisclosure of a reportable transaction other than a listed
transaction, but only in the narrowest of circumstances.93 However, Sarbanes-Oxley prohibits waiver and
any administrative or judicial appeal of the penalty for nondisclosure of a listed transaction —in other
words, the IRS examining agent’s determination that a return includes an undisclosed listed transaction is
arguably final.94 Though it may still be possible to litigate the narrow question as to whether a transaction
is listed. There is not, however, a reasonable cause exception and no judicial appeal of an IRS decision not
to waive penalties on reportable transactions. Paradoxically, if these penalties had applied to the successful
taxpayers in Coltec and Black and Decker —cases involving transactions which appear to be reportable
today —their refunds would not have included the penalties.
The Jobs Act also creates a new accuracy-related penalty regime to apply to adjustments due to listed
transactions and reportable transactions that have a “significant tax avoidance purpose.” 95 If a taxpayer has
properly disclosed such a transaction, and an adjustment arising from that transaction is upheld, the
taxpayer is penalized an amount equal to 20 percent of the adjustment, calculated at the highest prevailing
tax rate, while failure to disclose such a transaction increases the penalty to 30 percent of the adjustment.96
Waiver of this penalty is possible if the taxpayer “reasonably believed” that the claimed tax treatment was
more likely than not the proper tax treatment.97 In case the penalty is missed in auditing an earlier year, the
Jobs Act extends the statute of limitations for assessment of tax arising from a listed transaction until one
year after the taxpayer or a material advisor has properly disclosed the listed transaction to the IRS. 98 This
complicates document retention policies, since, until disclosure is made, the statute of limitations on
assessment and collection of any related deficiencies does not run. 99
Over the last few decades, Congress seems to have accepted as an article of faith that taxpayers can be
penalized into better observance of their tax obligations, however confusingly they are drafted. The Jobs
Act builds on this tradition by handing to the IRS broad new powers to proscribe transactions that it
perceives to be tax shelters, compel their prompt disclosure and penalize with increasing severity any
defaulters netted on audit. Cynical or not, this strategy seems misguided. Penalties are not predictable and
the severity of penalties in relation to the offense can give rise to intimidation by examiners. All of this can
result in a diminution with respect to the overall effectiveness of the system. Not surprisingly, it is
necessary to strike a balance, especially where there is no reasonable cause exception.
Efforts by the IRS to combat overly aggressive reporting through substantive measures also can backfire.
The recently withdrawn Notice 98-5100 offers an example. The notice was intended to curb abusive
transactions involving foreign tax credits, and included several examples to illustrate its purpose. However,
some practitioners interpreted the rules to supply a strict set of “numerically based planning rules” and thus
a safe harbor, rather than broader guidance on avoiding a category of abusive transactions. 101 Not all
commentators take such a dim view of the IRS’s ability to combat aggressive tax avoidance transactions
through enforcement mechanisms and regulatory action. 102 However, despite some successes over the last
decade, the Commissioner noted in his remarks at the beginning of this year that much remains to be
done.103
IRS action alone cannot end corporate tax shelters. While the various agency and court actions to combat
promoters and streamline dockets no doubt played a significant part in the efforts to combat individual tax
shelters twenty years ago, it was not until the passive activity loss limitation rules under Code Sec. 469
took effect that the use of individual shelters markedly decreased. 104 Granting the IRS these new disclosure
powers may have a deterrent effect, but the grant of these powers is not comparable to the enactment of the
passive activity rules. An effort to create such a rule in the Jobs Act illustrates the difficulty such legislation
faces. The legislative history of efforts in the Jobs Act to capture in bloated, attenuated legislative terms the
common law economic substance doctrine provides an object lesson in the futility of this legislative habit
which one prominent practitioner has termed hyperlexis.105 The evolution of the doctrine of substance
versus form in the tax law has been a judicial work in progress for decades. Bar associations and others
have warned against attempts to encase the doctrine in a legislative straightjacket, partly out of fear that
defining it would impede the flexibility of courts in developing it.106 Another criticism is that a statutory
rule clear enough to be administrable and broad enough to be effective would impede legitimate
transactions. The Senate version of the Jobs Act would have codified the doctrine by requiring that a
taxpayer would have had to prove that the questioned transaction changed in a meaningful way (apart from
tax effects) the taxpayer’s economic position.107 In addition, the taxpayer would have had to prove a
substantial nontax purpose for entering into the transaction and that the transaction was a reasonable means
of accomplishing that purpose. A financial accounting benefit would not have constituted a substantial
nontax business purpose if the origin of the benefit was a reduction of income tax. Two additional rules,
relating to pre-tax profit potential and transactions with tax indifferent parties, also festooned the provision.
Questions arose as to whether these criteria would be reduced to objective formulae which, if met, would
minimize a transaction from further investigation. Perhaps sensing that the proposal threatened to embalm
judicial doctrines rather than clarify them, the conferees dropped it from the final bill, opting instead for the
less contentious procedural strategies of more disclosure and more penalties. Until substantive reform is
achieved, the ability of the IRS to stem the flow of aggressive corporate tax schemes under current law
depends less on enforcement than on whether companies and their advisors can be returned to more
conservative tax planning and reporting.
As the new Jobs Act wound its way through Congress, it became so festooned with special interest
provisions, that there have been taunts that the “Jobs” of its title are those of Washington’s lobbyists. The
Jobs Act is but the latest evidence of the disintegration of the process by which tax laws are formulated.
Older tax lawyers recall the days when the Assistant Secretary of the Treasury would present to the House
Committee on Ways and Means a draft bill, carefully conceived and drafted, introduce and discuss it at the
beginning of prolonged, open hearings, and then work for weeks, both before and after introduction, with
the Chairman to respond to criticisms and members’ requests. The Joint Committee on Internal Revenue,
staffed by wise and experienced tax professionals, led by a chief respected by the chairmen of the taxwriting committees in both houses, monitored the tax policy decisions, coordinated and frequently
controlled the actual crafting of language, which proceeded deliberately, carefully and under the harsh
testing of career legislative aides. What emerged from this process, gradually, were reasonably coherent
legislative compromises with the Administration’s tax initiatives.
The Jobs Act is not the creature of such a process. Today’s Assistant Secretary and Tax Legislative
Counsel do not propose, but react to Congressional initiatives. Much of the time, they are simply out of the
legislative loop. Drafting is shifting from the Joint Committee to the majority and minority staffs of the taxwriting committees and, from them to lobbyists and their sympathetic committee members. Their work is
often insufficiently edited and drafted too close to deadlines to allow public response and mature thought.
Despite campaign rhetoric, Congress seems to like it that way. Emblematic of the triumph of special
interests over tax reform was its late casualty in the process. Lobbyists and their representatives in
Congress succeeded in eliminating from the final Act a provision which would have established a blue
ribbon, bipartisan commission of experts to develop a plan for comprehensive reform of the Internal
Revenue Code. Too many members of both houses seem to prefer our increasingly corrupt system of tax
legislation just as it is. During this fall’s election campaign, the President promised a study of tax reform,
but Congress’ abandonment of a similar provision in the “Jumpstart Our Business Strength” (JOBS) Bill 108
is not encouraging. When the bonanza of giveaways in the Jobs Act is compared with estimated revenue
losses from tax shelters, it is hard to stifle a question as to which is the greater enemy of a sound corporate
income tax: shelter promoters or Congress? Might not the fisc have benefited at least as greatly by
advancing substantive reform as by Congress’s self-righteous attacks on shelters?
If reform does get off the ground, Congress must be willing to repair not only the dysfunctional legislative
process, but also tax legislative drafting. Before the enactment of the 1954 Code, tax provisions tended to
be crafted in language akin to other legislation in more general terms. The laws left room for administrative
and judicial interpretation, to be applied as appropriate under specific circumstances. With the 1954 Code,
this approach gave way to a more specific and complex style of drafting in the naïve belief that Congress
could create such a comprehensive network of objective rules that there would be little room for
controversy in the future. The highly articulated statute which has mushroomed from this approach has
only increased the gaming of the tax law. In the Jobs Act, this legislation style has been used to turn the
Code on its head, is manufacturing industry-specific pork —and, almost certainly, opens the door to more
opportunities for gaming.
5. Redefining the Responsibilities of Tax Professionals
To curb dubious legal opinions circulated during the individual tax shelter wave of the 1970s and 1980s,
the IRS and the Treasury promulgated higher standards for tax opinions in Circular 230, which governs the
conduct of professionals before the IRS. They have done so again. 109 The latest proposed changes were
prompted by a perceived failure of tax advisors to provide clients with suitable and realistic guidance.
Anecdotal evidence includes accounts of attorneys providing “cookie-cutter” tax opinions based on
assumptions that bear no resemblance to the circumstances actually facing clients in question. 110 Among
the proposed changes is a set of “best practices” for practitioners, a number of which admonish
professionals to base their advice on verified information and reasonable assumptions. The amendments
would also address tax shelter opinions that either reach a “more likely than not” conclusion or are
marketed in the promotion of a tax shelter, requiring them to be based on known facts. They would require
opinions to recite that they may not shield the taxpayer from liability for accuracy-related penalties.
To many lawyers, these proposals should hardly require promulgation, since they echo present standards of
professional practice. However, some published standards which guide the behavior of lawyers and/or
accountants, whether as independent advisors or tax department officers, appear to sanction aggressive
returns and stealth reporting. ABA Opinion 85-352 provides:
[A] lawyer may advise reporting a position on a return even where the lawyer believes the
position probably will not prevail, there is no “substantial authority” in support of the position,
and there will be no disclosure of the position in the return. However, the position to be
asserted must be one which the lawyer in good faith believes is warranted in existing law or can
be supported by a good faith argument for an extension, modification or reversal of existing
law. This requires that there is some realistic possibility of success if the matter is litigated. In
addition, in his role as advisor, the lawyer should refer to potential penalties and other legal
consequences should the client take the position advised.111
The realistic possibility standard set out in this opinion has been interpreted by a special task force of the
ABA Tax Section to mean “more than a five-percent or 10-percent chance” of success —an interpretive
conclusion that may be surprising to some.112 Understatement penalties under Code Sec. 6694, as well as
guidelines articulated in Circular 230 also adopt this “realistic possibility” standard, though in those cases
the standard has been interpreted to require at least a one-in-three probability of success.113
These standards, however, address only minimum benchmarks for practitioners to advise taxpayers on
steering shy of penalties.114 They do not require a level of accuracy and quality that, if made the norm,
would be sufficient for sound administration of a tax system which relies on self-assessment. Such low
standards reveal a failure to distinguish between the threshold at which a penalty should be imposed and an
advisor’s professional duty to advise on how a return should be filed. A tax return is not a litigating party’s
least permissible argument, nor is it a first offer in settlement of a dispute. It is a self-assessment of a
taxpayer’s liability, declared to be true, complete and accurate. Advice given in assisting that declaration
should be at no lower standard of confidence, and penalties should not set the threshold at which advice is
given. The current ABA and Circular 230 standards may have created confusion as to standards of advice.
Certainly, they are inadequate to curb abusive tax transactions. 115 In a climate of intense pressure to meet
earnings targets, there can be little doubt that some practitioners have been content to ply their trade at
these minimum thresholds, or have fallen below them. Enron, for example, is reported to have implemented
numerous aggressive tax structures as part of its strategy to inflate reported profits and its stock price. 116
Addressing these highly structured Enron transactions, the chief of staff of the Joint Committee on
Taxation testified that “I do not know if you could call it illegal.” 117 Whether the Jobs Act will provide
better tools for the enforcement of Circular 230 violations is to be seen. It equips the IRS with a new
arsenal of remedies to use against practitioners in violation of Circular 230. For instance, the IRS may now
fine, censure, disbar, suspend or obtain injunctive relief against practitioners. These remedies coupled with
an increased enforcement activity may have more success than previous efforts.118
A second source of confusion over the proper standards of tax practice is the nature of the relationship
between an advisor and a corporate client. The nature of such representations —and the applicable legal
and ethical standards —should take into account the relationship between the company and the IRS. 119 Yet
it is not clear, in a system of self-assessment and contentious audits, how adversarial this relationship is.
Should the advisor to the company represent the client with the zealous advocacy typical of litigation, or
serve in a more advisory role, assisting the client in compliance without overpayment? The answer, like so
many in practice, depends upon the circumstances of each case. Even the most experienced and wellintentioned practitioners may disagree about the legitimacy of a transaction. Witness the dissenting opinion
of Judge McKee in ACM, and the reversals of opinions of the lower court regarding a questionable
transaction as in UPS and Compaq.120 The IRS Office of Professional Responsibility has recently taken a
more active role in sanctioning Circular 230 violations,121 and the IRS now regularly notifies state bar
associations and boards of accountancy when practitioners are sanctioned for Circular 230 violations.122
If the current legal and ethical standards governing professional conduct do not supply a satisfactory
benchmark, what does? Mr. Justice Holmes reminded us long ago that the object of the study of law is to
predict how courts will rule: “[t]he prophecies of what the courts will do in fact, and nothing more
pretentious, are what I mean by the [the practice of] law ...” 123 The work of tax lawyers is no different from
that of other lawyers. They must prophesy as to how a court will rule, being fully advised. This is a
responsibility quite different from the standards of permitted advocacy which underlie ABA Opinion 85352 and Code Sec. 7430(c)(3)(B), which exempts the government from being assessed costs as long as a
losing position was “substantially justified.” Tax lawyers who take as their starting point a strained reading
of the text of the Code and regulations, stop there at their peril, whether they advise taxpayers or the
government. The judge-made common law of taxation predates even our 90 years of the modern income
tax. In making sense of the Code, judges have interpreted its meaning by reference to Congressional intent.
In the process, they have developed judicial doctrines whose application must be weighed by every tax
lawyer giving advice. Their application may be more or less predictable, and, as the recent trial court losses
by the government reveal, they may be virtually ignored by some judges who will let the letter of the law
lead them away from its spirit. The Court of Federal Claims judge in Coltec even completed her opinion by
proclaiming that “use of the ‘economic substance’ doctrine to trump ‘mere compliance with the Code’
would violate the separation of powers.”124 The court found support for this extraordinary statement in
D.A. Gitlitz,125 in which the majority of the Supreme Court endorsed a literal and admittedly anomalous
reading of the Code, forcing immediate repair by Congress. Yet the court’s approach to its duties in Coltec
must be contrasted with that of the Tax Court and Court of Appeals in ACM,126 which acknowledged that a
literal reading of the contingent sale regulations under Code Sec. 453 might support the taxpayer, but
refused, on the doctrinal grounds of business purpose and economic substance to countenance a result
Congress could never have intended. However uncertain may be the courts’ reliance on such judicial
doctrines, their possible application cannot be dismissed in forming a prophesy as to how a court may rule.
Keeping such uncertainties in mind better serves the interests of companies and professionals alike than
overconfident toleration of schemes to reduce taxes which may eventually be more costly than the tax
savings.127 Government counsel as well must be alert to such imponderables. Designated issues and
formula settlement may be necessary evils in managing growing case loads, but IRS appellate conferees
and trial counsel should not be prevented by such policies from acting on their own judgment of litigation
hazards. The history of formula settlements is that only the weakest taxpayer cases settle out, while the
stronger ones go to trial. Government counsel should be able to cull out and settle the stronger taxpayer
cases and force to trial those offering the best chances for government success. Inflexible formula
settlement policies turn this strategy on its head, trapping the government into defending the wrong test
cases, as may have happened in the recent defeats in Castle Harbour, Coltec and Black and Decker.
Should Corporate Tax Directors Set a New Course?
Commissioner Everson recently observed that “[o]ur system of tax administration depends upon the
integrity of practitioners. The vast majority of practitioners are honest and scrupulous, but even they
suffered from the erosion of ethics by being subjected to untoward competitive pressures. The IRS is
acting.”128 The Commissioner’s statement recognizes that tax professionals, whether currently sitting as
corporate tax directors, private counsel or government officers, are all administrators of the corporate
income tax. The law’s integrity is a common responsibility. Current pressures to reduce taxes by any means
may have originated outside tax departments and competition among professional firms to meet the
demands for a quick fix may be blamed in part on sales pressures. Inevitably, however, adoption by
companies of precariously artificial tax products is the responsibility of tax professionals. It is hard to take
issue with the Commissioner on this point. The use of corporate tax shelters has set off a vicious cycle of
taxpayer abuse and government punitive responses. The costs of this cycle to both sides cannot be
measured in revenue losses, penalties or resource burdens alone. The self-assessment system itself is at
stake. When the IRS and Congress are unable to rely on self-assessment and begin to construct a
compelled, inquisitorial system of tax collection, mutual mistrust leads to pervasive stealth reporting,
streams of costly IDRs and uncertainty as to ultimate tax liabilities.
Such a vicious cycle is not due alone to what the Commissioner terms “erosion” of practitioners’ ethics due
to “untoward competitive pressure.” It is compounded by the increasing complexity, artificiality and overarticulation of the law itself. The cycle will be broken only when tax professionals, whether in government
or private practice, steer by the same pole star: how a court should be expected to rule, if fully informed. In
this light, the corporate tax director’s course should remain fixed: away from a vicious cycle of aggressive
reporting and equally aggressive audits toward a virtuous cycle of sound tax planning, return positions that
are respected and tax estimates that can be relied upon by the company.
*
The author expresses his deep appreciation to Thomas Allen Stenger and Gregory Hannibal for their
collaboration in the early stages of preparing this paper, to his colleague Wendy Charon Unglaub for her
thoughtful review and improvements, to Mario Verdolini for his critical reading and suggestions and to
William Gifford for his helpful comments. Remaining errors are solely those of the author.
1
Paul Braverman, Helter Shelter, AM. LAW., Dec. 2003.
2
See id. (citing to General Accounting Office, IRS, Transactional Records Access Clearinghouse).
3
See id. (citing to General Accounting Office, IRS, Transactional Records Access Clearinghouse).
4
American Jobs Creation Act of 2004 (P.L. 108-357).
5
See Marianne Stenvig, Herseth for Small Businesses, ABERDEEN AM. NEWS, Oct. 25, 2004, at 4; Peter
B. Levy, Bush’s Failure to Veto a Sign of Weakness, MYRTLE BEACH SUN-NEWS, Oct. 24, 2004, at 5.
Bush Repeals US Export Tax Break Ruled Illegal by WTO, AFX.com, Oct. 22, 2004, AFX ASIA, Oct. 23,
2004; Bush Signs Corporate Tax Bill, Legislation Aids Energy Companies, PLATTS COMMODITY
NEWS, Oct. 22, 2004.
6
Although a recent wave of court cases decided in favor of taxpayers, which the IRS charged were shelters,
may arguably indicate otherwise. See TIFD III-E Inc., DC Conn., 2004-2 USTC ¶50,401, 342 FSupp2d 94
(holding that an aircraft leasing partnership was not a sham despite a tax favorable shift of income to
offshore partners because the transaction had a business purpose and economic reality) [hereinafter, Castle
Harbour in text]; Coltec Indus., Inc., FedCl, 2004-2 USTC ¶50,402 (Oct. 29, 2004) (holding that a taxpayer
was entitled to deduct losses realized from the sale of stock in a newly formed subsidiary, where the
taxpayer had transferred its assets along with its contingent liabilities relating to asbestos claims); Black &
Decker Corp., DC Md., 2004-2 USTC ¶50,390, 340 FSupp2d 621 (finding that a taxpayer could claim a
loss on the sale of the stock of a newly formed subsidiary where the taxpayer transferred its assets in
addition to contingent employee health care claims to the subsidiary in exchange for the subsidiary’s
stock).
7
See Sheryl Stratton, IRS, Justice Officials Discuss Booming Criminal Tax Business, 2004 TNT 214-3
(Nov. 4, 2004) (reporting, from a recent criminal tax fraud meeting sponsored by the ABA, that the IRS
intends to investigate civil, criminal and Circular 230 violations concurrently).
See United Parcel Service of America, Inc., 78 TCM 262, Dec. 53,497(M), TC Memo. 1999-268, rev’d,
CA-11, 2001-2 USTC ¶ 50,475.
8
ACM P’ship, CA-3, 98-2 USTC ¶50,790, 157 F3d 231, rev’g, 73 TCM 2189, Dec. 51,922(M), TC Memo.
1997-115.
9
10
See, e.g., Floyd Norris, Where Did the Value Go at Enron, N.Y. TIMES, Oct. 23, 2001, at C1.
11
Id.
12
Tax Equity Fiscal Responsibility Act of 1982 (P.L. 97-248).
13
All section references are to the Internal Revenue Code of 1986, as amended (“the Code”).
14
Deficit Reduction Act of 1984 (P.L. 98-369).
15
See, e.g., J.J. Tallal, Jr., 48 TCM 1082, Dec. 41,482(M), TC Memo. 1984-486 (denying deductions on a
limited partner’s distributive share of partnership losses where the court found that the limited partnership
did not exist for a valid business purpose); S.I. Snyder, 49 TCM 452, Dec. 41,810(M), TC Memo. 1985-9
(denying deductions and an investment credit to an individual taxpayer where the court found that the
purchase of a master recording lacked business purpose); G.V. Zmuda, 79 TC 714, Dec. 39,468, aff’d, CA9, 84-1 USTC ¶9442, 731 F2d 1417 (describing both the economic substance and business purpose
doctrines).
16
See Code Sec. 704(b).
17
See Code Sec. 163(d).
18
See Code Sec. 461(g).
19
See Code Secs. 1271-1275.
Brian R. Lynn, But I Don’t Sell Tax Shelters! The Expanding Reach of the Code Sec. 6700 Promoter
Penalty, TAXES, June 2004, at 39.
20
21
The taxpaying public often does not react well to such increased disclosure requirements. An example is
the so-called “Eleven Questions” the IRS began to pose to taxpayers in 1976 with respect to slush funds.
See, e.g., Anthony L. Bartolini, Responding to the IRS’ “Eleven Questions” Investigations: Where
Practitioners Stand, 48 J. TAX’N 16 (Jan. 1978). The questions were quite vague and burdensome to
answer, such that the IRS eventually abandoned the program following public outcry.
22
Tax Reform Act of 1986 (P.L. 99-514).
23
See, e.g., George K. Yin, Getting Serious About Corporate Tax Shelters: Taking a Lesson from History,
54 SMU L. REV. 209 (Winter 2001); Steven C. Todrys, What’s My Line? The Role of the Tax Lawyer in
the Post-Enron World, TAX FORUM No. 568, Oct. 7, 2003.
24
In recent months, at least three major tax shelters have been the source of media attention. All three have
been disputed in federal district courts and the Court of Claims, and have been resolved against the
government. See supra note 6.
25
See, e.g., Dept. Treasury, The Problem of Corporate Tax Shelters: Discussion, Analysis and Legislative
Proposals, July 1999, at I [hereinafter “Treasury White Paper”].
26
In the past year alone, a former mid-level tax manager at Dynegy, Inc. was sentenced to more than 24
years in prison, without parole, for his involvement in a financial scheme known as “Project Alpha.” See
Susan Warren, Refusing to Talk, Dynegy’s Olis Goes to Prison, WALL ST. J., May 20, 2004, at B1; Simon
Romero, Former Dynegy Employees Face Charges of Fraud, N.Y. TIMES, June 13, 2003, at C1; Sue
Herera, Dynegy has been using accounting arrangement called Project Alpha to Make its Books Look
Better, CNBC News Transcripts (Apr. 3, 2002).
27
Minority Staff of the Permanent Subcommittee on Investigations of the Committee on Governmental
Affairs, United States Senate, U.S. Tax Shelter Industry: The Role of Accountants, Lawyers, and Financial
Professionals: Four KPMG Case Studies: FLIP, OPIS, BLIPS, and SC2, at 3 and 4 (Nov. 18 and 20, 2003)
[hereinafter “KPMG Report”]. See generally Treasury White Paper, supra note 25.
See, e.g., L.G. “Chip” Harter, Observations on Disclosure, Transparency and Taxpayer Compliance,
TAXES, Mar. 2004, at 129.
28
29
Taxpayer Relief Act of 1997 (P.L. 105-34).
30
It should be noted that, in the narrow circumstances in which no promoter is a U.S. person and the
transaction has not been registered, the taxpayer-participant is required to register the product and faces the
same penalties if it does not. See Code Sec. 6111(d)(3).
31
Reg. §301.6111-2(c)(3).
32
Treasury White Paper, supra note 25.
33
Reg. §§1.6011-4 and 301.6112-1.
34
See Section 4, infra.
35
IES Industries, Inc., CA-8, 2001-2 USTC ¶50,471, 253 F3d 350; Compaq Computer Corp., 113 TC 363,
Dec. 53,628 (1999), rev’d, CA-5, 2002-1 USTC ¶50,144, 277 F3d 778.
36
For example, few, if any, companies have software that tracks both tax and book consequences of a
transaction, making it extremely onerous to determine whether the transaction possesses a “significant
book-tax difference” and is thus reportable. See Harter, supra note 28, at 143.
37
Notice 2000-15, 2000-1 CB 826.
38
Notice 2004-67, IRB 2004-41, 600.
39
See, e.g., Harter, supra note 28, at 134.
40
See id. With the advent of the Jobs Act, companies and tax practitioners alike now face substantial
penalties by failing to disclose penalties from failure to disclose a listed or reportable transaction. See Code
Sec. 6707A.
41
See Code Secs. 6708, 6112 and Act Sec. 815 of the Jobs Act. See also Notice 2004-80, IRB 2004-50
(Nov. 16, 2004).
42
Sarbanes-Oxley Act of 2002 (P.L. 107-204).
43
ARTHUR LEVITT, TAKE ON THE STREET: WHAT WALL STREET AND CORPORATE
AMERICA DON’T WANT YOU TO KNOW: WHAT YOU CAN DO TO FIGHT BACK, at 138 (2002).
44
Empirical evidence that would ascertain the effect of nonaudit services on audit quality is inconclusive,
despite the SEC’s requirement since February 2001 that issuers publicly disclose nonaudit fees paid in
proxy statements. See Richard M. Frankel, Marilyn F. Johnson & Karen K. Nelson, Auditor Independence
and Earnings Quality: Relation between Auditors’ Fees and Non-Audit Services and Earnings
Management, GSB Research Paper 1696R, Stanford Graduate School of Business Research Paper Series
2001. But see Hollis Ashbaugh, Ryan La Fond, & Brian Mayhew, Do Non-Audit Services Compromise
Auditor Independence? Further Evidence, University of Wisconsin working paper (Feb. 20, 2003) (no
correlation found between issuers’ positive discretionary accruals and the ratio of audit to nonaudit fees in a
study that controlled for the issuers’ prior performance, a factor that can itself be related to income
increasing accruals); J. Kenneth Reynolds, Donald R. Dels, Jere R. Francis, Professional Service Fees and
Auditor Objectivity, AUDITING-J. PRAC. & THEORY, Vol. 23, Issue 1, at 29 (observing that the
correlation between aggregate levels of discretionary accruals and the ratio of consulting fees to audit fees
disappears when controlling for high growth issuers). Other studies also have not detected a relationship
between audit firms’ fees and evidence of earnings management. See, e.g., HYEESOO CHUNG &
SANJAY KALLAPUR, CLIENT IMPORTANCE, NON-AUDIT SERVICES, AND ABNORMAL
ACCRUALS (Dec. 2001) (finding no statistically significant association between abnormal accruals by
issuers and “client importance” measures such as the ratio of both audit and nonaudit fees to the audit
firm’s total U.S. revenues or to the revenues of a particular office of the audit firm). See, e.g., Mark
DeFond, Kannan Raghunandan and K.R. Subramanyam, Do Non-Audit Service Fees Impair Auditor
Independence? Evidence from Going-Concern Audit Opinions, 40 J. ACCT. RES. 1247 (2002) (finding no
significant correlation between the auditor’s willingness to issue a going concern opinion with respect to an
issuer and either total fees or audit fees paid by the issuer to its audit firm).
45
SEC Release No. 33-8183.
46
Id.
See, e.g., Bernard Wolfman, Accountants —Audit Standards: ‘Sarbanes-Oxley’ Needs Fixing, 71 U.S.
LAW WEEK 2083 (Aug. 13, 2002); Linda M. Beale, Putting SEC Heat on Audit Firms and Corporate Tax
Shelters: Responding to Tax Risk with Sunshine, Shame and Strict Liability, 29 IOWA J. CORP. L. 219
(Winter 2004).
47
48
Empirical studies of the influence on audits by their own tax advisor may be difficult to undertake, but
the appearance of conflict is clear when a firm is compensated simultaneously for tax planning and
certifying the adequacy of contingent reserves against its companies.
49
SEC Release No. 33-8183.
50
SEC Release No. 2003-94.
51
SEC Release No. 33-8183.
52
LEVITT, supra note 43.
George R. Goodman, The Taxpayer’s and Tax Advisor’s Guide to Sarbanes-Oxley, 2003 TNT 150-29
(Aug. 4, 2003).
53
54
The Jobs Act legislation apparently involved another such unsuccessful effort.
55
See Jonathan Weisman, IRS Speeds Corporate Tax Audits; Fast-Track Method May Miss Fraud, WASH.
POST, Dec. 29, 2003, at A01.
56
Sheryl Stratton, Justice Officials Discuss Booming Criminal Tax Business, 2004 TNT 214-3 (Nov. 4,
2004).
57
Id.
58
See IRS News Release, IR-2004-14, Jan. 28, 2004. See also TEI Calls for Delay in Implementation of
Proposed Schedule M-3, 2004 TNT 110-17 (June 7, 2004).
59
See IRS News Release, IR-2003-73, June 3, 2003.
60
See IRS News Release, IR-2002-133, Dec. 4, 2002.
61
See IRS News Release, IR-2000-7, Feb. 11, 2000.
62
Stipulation for Resolution of Issue through Voluntary Binding Arbitration Under Tax Court Rule 124,
filed in Apple Computer, Inc. and Consolidated Subsidiaries, No. 21781-90 (U.S. Tax Court). See also
Kenneth B. Clark, Ronald B. Schrotenboer, William A. Fenwick and Philip J. Bergquist, A Different
Approach to Resolving Section 483 Disputes, 55 TAX NOTES 1813 (June 29, 1992) (detailing the Apple
Computer arbitration from the perspective of Apple Computer’s counsel).
63
See IRS News Release, IR-2002-78, June 17, 2002.
64
See Arthur Young & Co., SCt, 84-1 USTC ¶9305, 465 US 805, 104 SCt 1495.
65
See Announcement 84-46, IRB 1984-18, 18.
66
See Lee A. Sheppard and Sheryl Stratton, News Analysis: Williams Advocates Tax Accrual Workpaper
Policy Changes, 2003 TNT 203-9 (Oct. 21, 2003).
67
See Harter, supra note 28, at 148.
68
Id., at 148-49.
69
Arthur Young, supra note 64, at 820-21.
70
See IRS Manual Supplement 42G-329 (1976).
71
See Bartolini, supra note 21, at 18.
72
See id.
73
See IRS News Release, IR-1943, Jan. 20, 1978; see also Bartolini, supra note 21, at 17-18.
74
Letter from Sherwin P. Simmons, Retiring Chairman, Section of Taxation, American Bar Association, to
Donald C. Alexander, Commissioner of Internal Revenue, Internal Revenue Service (Aug. 2, 1976)
(reprinted in 30 TAX LAW. 10 (1976)).
75
Supra note 66.
76
See id.
77
See id.
78
See IRS News Release, IR-2004-34, Mar. 15, 2004.
ACM P’ship, supra note 9. The Tax Court’s exhaustive findings in ACM indicate an equally exhaustive
investigation by IRS agents and lawyers in preparing the case for trial.
79
80
18 USC §1519. See also Dana E. Hill, Anticipatory Obstruction of Justice: Pre-Emptive Document
Destruction Under the Sarbanes-Oxley Anti-Shredding Statute, 18 U.S.C.A. 1519, 89 CORNELL L. REV.
1519, at 1521-22 (Sept. 2004).
81
Arthur Andersen, LLP, DC Tex., Dkt. No. 02-121 (Mar. 14, 2002).
82
Quattrone, Indictment P 16-44, available at
http://news.findlaw.com/hdocs/docs/csfb/usquattrone51203ind.pdf. In one interchange, one of Quattrone’s
colleagues noted “Today, it’s administrative housekeeping. In January, it could be improper destruction of
evidence.” Quattrone cautioned the colleague that he “shouldn’t make jokes like that on email!”
83
Three provisions have been used in prior obstruction of justice cases, 18 USC §§1503, 1505 and 1512(b).
These statutes generally require specific knowledge of proceedings and an intention to obstruct them.
84
Hill, supra note 80.
85
18 USC §1519.
86
A thoughtful discussion of Code Sec. 1519 and a collection of cases leading up to its enactment are
contained in Hill, supra note 80.
87
Supra note 4.
88
New Code Sec. 6707A; see Act Sec. 811 of the Jobs Act; H.R. 4520, §611; S. 1637, §402.
89
New Code Sec. 6707A(b)(1)(B)-(2)(B).
90
Compare New Code Sec. 6707A(b)(1)(B) and (2)(B) with New Code Sec. 6707A(b)(1)(A)-(2)(A).
91
Act Secs. 815, 816 and 817 of the Jobs Act (amending Code Secs. 6111, 6112 and 6708); see A Guide to
the American Jobs Creation Act of 2004, TAX NOTES, Oct. 18, 2004.
92
New Code Sec. 6707A(e).
93
Act Sec. 811 of the Jobs Act, at new Code Sec. 6707A(d)(1).
94
At new Code Sec. 6707A(d)(1), (2).
95
H.R. 4520, §612; S. 1637, §403.
96
Code Sec. 6662A(a)-(c).
97
Code Sec. 6664(d).
98
H.R. 4520, §614; S. 1637, §416.
99
Code Sec. 6501(e)(10).
100
Notice 98-5, 1998-1 CB 334.
101
See Frank J. Gould, Enron and the Boundaries of Aggressive Tax Advice, TAXES, July 2004, at 25.
102
See id.
103
See IRS News Release, IR-2004-34, Mar. 15, 2004.
104
See supra note 9.
Gordon D. Henderson, Controlling Hyperlexis —The Most Important “Law and ...” 43 TAX LAW. 177
(Fall 1989).
105
106
See David P. Hariton, Stop Calling It Economic Substance, 99 TAX NOTES 1543, 2003 TNT 111-51
(June 9, 2003).
107
See S. 1637, §401.
108
S. 1637.
109
Regulations Governing Practice Before The Internal Revenue Service, 68 FR 75186, REG 122379-02.
110
See, e.g., Lynnley Browning, Top Tax Shelter Lawyer No Longer at a Big Firm, N.Y. TIMES, June 30,
2004, at C1.
111
ABA Opinion 85-352 (July 7, 1985).
112
See Gould, supra note 101, at 13.
113
See id.
114
See id., at 3.
115
See id., at 14.
116
See generally Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related
Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Feb. 2003.
117
Id., at 5.
118
See infra notes 121-122 and accompanying text.
119
See id., at 8.
120
See id., at 6.
121
Sheryl Stratton, Justice Officials Discuss Booming Criminal Tax Business, 2004 TNT 214-3 (Nov. 4,
2004).
122
Id. The Jobs Act has also crafted additional penalties for violation of professional obligations.
123
Oliver Wendell Holmes, The Path of the Law, 10 HARV. L. REV. 457 (1897).
124
Coltec Indus., Inc., supra note 6.
125
D.A. Gitlitz, SCt, 2001-1 USTC ¶50,147, 531 US 206, 121 SCt 701.
126
ACM P’ship, supra note 9.
127
Notably, the Jobs Act now also imposes monetary penalties for failures to disclose reportable
transactions. The penalties are assessed and imposed without regard to whether the taxpayer will eventually
prevail on the merits of a transaction. See Code Sec. 6707A.
128
IRS News Release, IR-2004-34, Mar. 15, 2004.